Imagine taking a walk on a sunny day through your favourite park, when you start to notice that many of the other strollers are buckling on armoured vests. No screams, loud sounds or raised voices, but people are getting ready for something.
Disconcerting, you would think. And that is what is happening now in the futures markets and among the clients of commodities funds.
Equity markets are bubbling at high levels, bond markets are perking along without flash crashes or volatility spikes and even commodities are in positive territory for the year. Whatever the headlines about US president Donald Trump, North Korea or the shakiness of Greece and the uncertainty about European electorates, the surfaces of risk-market pools are remarkably calm.
Increasingly, though, I am hearing large, conservative, real money investors talk about how they can find relatively low-cost methods to hedge themselves against a market crash. Not a grinding decline, but a crash.
This sense goes beyond anecdotal chit-chat with, say, Canadian pension funds or risk-averse family offices. The US futures market even has an index to measure the level of uneasiness in the risk markets.
That would be the Skew index, a sort of patent medicine for the worried investor. I am not recommending the index, which is compiled by the CBOE, the largest US options exchange. All of these synthetic products created by commodities dealers and traders tend to be ways for the professionals, not you, to make money.
Nevertheless, the Skew index provides some interesting information. Very roughly speaking, Skew measures the difference between the cost of buying protection against a sharp market decline (a put option on the S&P 500) and the cost of buying the right to participate in a sharp market rally (a call option on the S&P 500).
Skew can range from close to 100 to a bit over 150. At the moment it is around 140, up from 125 in January, and at the high end of its range since the contract was introduced in 2011. That means the investors buying futures, as a group, are apparently willing to pay over the mathematical odds for protection against a market decline.
The Skew index is not in itself a reliable market-timing instrument, but it does indicate sentiment about the likely direction of the next significant market move. In April of last year, for example, after the Deutsche Bank panic of the early spring, Skew was down to around 114. Retrospectively, that was a good guess by those who disproportionately owned bullish call options.
There are other indications of worry by large investors. There has been a significant increase of investments in managed futures funds that optimise high returns during any market decline.
Quest Partners, a New York quantitative hedge fund company, was mentioned to me by several institutional investors when I started asking around about the cost of market-panic insurance.
Nigol Koulajian, the founder and chief investment officer of Quest, says: “We are known to be looking to trade in the direction of a potential volatility increase. Our flagship fund began 2016 with $396m under management, finished the year with close to $630m, and now has $884m. I am getting a lot more unsolicited calls from large institutions.”
Quest does not win big in every market environment. In 2011, Mr Koulajian says the flagship fund declined 4 per cent, and in 2016 rose 7 per cent. In 2007, though, when risk became more apparent, the fund rose 18 per cent, and then 56 per cent in 2008.
Mr Koulajian does not think most portfolio managers really add value to their investors’ returns.
“Our research shows that [managers’ asserted outperformance and risk management] appears to be skill, but is really correlated with convexity,” he says.
That convexity is the exposure of most market participants to sharp declines or increases in asset prices. Investors believe they have low-risk portfolios, but they do not.
There are other strategies than Mr Koulajian’s for betting on, or hedging against, the level of risk in markets. One interesting ploy I heard from the commodities market bears was to buy “structured product volatility” from Korean and Japanese banks.
Apparently, yield hungry retail investors in those countries will receive what they think is a single-digit income from a “product” sold by one of their banks. Actually, they are being paid option premiums for taking the risk of puts and calls on the local markets.
So the retail investors are being drawn into a game rigged against them over time, rather like those Italians who bought bank subinvestment-grade debt instruments thinking those were deposits. A lot of these apparently riskless bets will end very badly for the investors and those who misled them.